Wednesday, June 05, 2013

Falling Inflation Expectations, by Tim Duy: I had thought that early iterations of quantitative easing were flawed
because they were based on a fixed amounts of total purchases. The size and
length of the programs were effectively arbitrary as they were not linked to
economic outcomes. This, combined with clear indications that policymakers
desired to reduce the balance sheet as soon as possible, meant that the Fed was
not able to sufficiently affect longer term expectations about the future price
level or inflation to yield sustained improvement in economic activity.

In effect, the Fed was shooting itself in the foot with temporary programs.
I had thought that open-ended quantitative easing tied to economic outcomes
would resolve the problem of stabilizing expectations of future inflation, thus
supporting a "stronger and sustainable" recovery.

The initial gains in inflation expectations seemed to justify such optimism.
But a funny thing happened on the way to the show - inflation expectations
reversed course:

TIPS-measured inflation expectations began falling in March, and now stand at
pre-QE3 levels. Also telling is the Cleveland Federal Reserve Measures of
inflation expectations. Longer run expectations remain well below 2%:

and, with perhaps more important policy implications, the term structure of
expected future inflation has shifted down over the past year:

Arguably, by these measures a lot of policy has gone into accomplishing very
little. The Fed, however, will tend to take solace from the Survey of
Professional Forecasters:

The median is hovering near 2%, but at the bottom end of the range. So even if
financial markets are anticipating lower inflation, professional forecasters are
not. But professional forecasters really have not deviated from 2% since prior
to the crisis, whereas the Fed has seen sufficient numerous threats to price
stability to engage in repeated asset purchase programs. So one wonders how
much weight the Fed places on this measure. Or, probably more accurately, they
place more weight on this measure when it suits their purposes, such as if they
are interested in ending the asset purchase program.

Form the perspective of policy, however, I am not so confident the survey is
the best measure of inflation expectations. The Federal Reserve transmits
policy through financial markets, and if those markets are not signaling stable
or, more importantly, higher inflation expectations, then it is arguable that by
itself, quantitative easing has limited impacts on economic activity. It can
put a floor under the economy, but not accelerate activity.

Perhaps at best, quantitative easing does not cause higher inflation. At
worst, some argue it
is actually deflationary. The latter argument, however, will not get much
support at the Federal Reserve, at least not yet.

Alternatively, one could argue that the Fed can indeed affect inflation
expectations and really what is going on is that the Fed botched policy. Again.
This is the "they have some slow learners on Constitution Avenue" story.
Inflation expectations turned down in March, just when the Fed
started sending signals that tapering was on the horizon. In this story,
the Fed extrapolated a handful of data into the future and decided enough was
enough. But that data was endogenous to Fed policy, and threatening to remove
that policy once again undermined the economic outlook. In short, just by
talking about tapering in an uncertain economic environment, the Fed pulled the
plug on a successful policy.

But what should the Fed do now? Can they reverse the decline of inflation
expectations merely by ending expectations of tapering? I am somewhat doubtful;
the cat is out of the bag. They may very well have to expand asset purchases if
they want market participants to believe "no, we were just kidding."

Indeed, I suspect that at least one policymaker, current voting member St.
Louis Federal Reserve President James Bullard, would push for expanding asset
purchases given the inflation and inflation expectations data. It would be
interesting if he dissented a "hold steady" statement at the next meeting on
that basis.

There will be, however, strong resistance to raising the pace of asset
purchases. Yes, I know the Fed said they could move up or down. But I think the
idea of "up" would only come after a "down." And clearly, if inflation
expectations are any guide, market participants are getting the message that
"down" is what is coming. And they are not getting that from just the hawkish
policymakers. The doves too have been getting
in on the action.

Moreover, I have to imagine that the recent market action in Tokyo has made
some policymakers a little bit nervous about the limits to quantitative easing.
The Nikkei's rise and fall seems to indicate that at some point asset purchases
do in fact become destabilizing.

My view is that asset purchases would be most effective if coupled with
fiscal stimulus. Working only through financial markets may be simply too
restrictive to yield broad-based economic improvement. It is almost as if the
Fed is trying to force a fire hose of policy through a garden hose. Keep
turning up the volume, and eventually that hose bursts. And that might be what
we are seeing in Japan.

Bottom Line: Inflation expectations are falling, and that by itself should
complicate the Fed's expectation that they can start scaling back asset
purchases at the end of the summer. But falling inflation expectations may
complicate monetary policy more broadly by revealing the limits to quantitative
easing. And Japan isn't helping.

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Fed Watch: Falling Inflation Expectations

Tim Duy:

Falling Inflation Expectations, by Tim Duy: I had thought that early iterations of quantitative easing were flawed
because they were based on a fixed amounts of total purchases. The size and
length of the programs were effectively arbitrary as they were not linked to
economic outcomes. This, combined with clear indications that policymakers
desired to reduce the balance sheet as soon as possible, meant that the Fed was
not able to sufficiently affect longer term expectations about the future price
level or inflation to yield sustained improvement in economic activity.

In effect, the Fed was shooting itself in the foot with temporary programs.
I had thought that open-ended quantitative easing tied to economic outcomes
would resolve the problem of stabilizing expectations of future inflation, thus
supporting a "stronger and sustainable" recovery.

The initial gains in inflation expectations seemed to justify such optimism.
But a funny thing happened on the way to the show - inflation expectations
reversed course:

TIPS-measured inflation expectations began falling in March, and now stand at
pre-QE3 levels. Also telling is the Cleveland Federal Reserve Measures of
inflation expectations. Longer run expectations remain well below 2%:

and, with perhaps more important policy implications, the term structure of
expected future inflation has shifted down over the past year:

Arguably, by these measures a lot of policy has gone into accomplishing very
little. The Fed, however, will tend to take solace from the Survey of
Professional Forecasters:

The median is hovering near 2%, but at the bottom end of the range. So even if
financial markets are anticipating lower inflation, professional forecasters are
not. But professional forecasters really have not deviated from 2% since prior
to the crisis, whereas the Fed has seen sufficient numerous threats to price
stability to engage in repeated asset purchase programs. So one wonders how
much weight the Fed places on this measure. Or, probably more accurately, they
place more weight on this measure when it suits their purposes, such as if they
are interested in ending the asset purchase program.

Form the perspective of policy, however, I am not so confident the survey is
the best measure of inflation expectations. The Federal Reserve transmits
policy through financial markets, and if those markets are not signaling stable
or, more importantly, higher inflation expectations, then it is arguable that by
itself, quantitative easing has limited impacts on economic activity. It can
put a floor under the economy, but not accelerate activity.

Perhaps at best, quantitative easing does not cause higher inflation. At
worst, some argue it
is actually deflationary. The latter argument, however, will not get much
support at the Federal Reserve, at least not yet.

Alternatively, one could argue that the Fed can indeed affect inflation
expectations and really what is going on is that the Fed botched policy. Again.
This is the "they have some slow learners on Constitution Avenue" story.
Inflation expectations turned down in March, just when the Fed
started sending signals that tapering was on the horizon. In this story,
the Fed extrapolated a handful of data into the future and decided enough was
enough. But that data was endogenous to Fed policy, and threatening to remove
that policy once again undermined the economic outlook. In short, just by
talking about tapering in an uncertain economic environment, the Fed pulled the
plug on a successful policy.

But what should the Fed do now? Can they reverse the decline of inflation
expectations merely by ending expectations of tapering? I am somewhat doubtful;
the cat is out of the bag. They may very well have to expand asset purchases if
they want market participants to believe "no, we were just kidding."

Indeed, I suspect that at least one policymaker, current voting member St.
Louis Federal Reserve President James Bullard, would push for expanding asset
purchases given the inflation and inflation expectations data. It would be
interesting if he dissented a "hold steady" statement at the next meeting on
that basis.

There will be, however, strong resistance to raising the pace of asset
purchases. Yes, I know the Fed said they could move up or down. But I think the
idea of "up" would only come after a "down." And clearly, if inflation
expectations are any guide, market participants are getting the message that
"down" is what is coming. And they are not getting that from just the hawkish
policymakers. The doves too have been getting
in on the action.

Moreover, I have to imagine that the recent market action in Tokyo has made
some policymakers a little bit nervous about the limits to quantitative easing.
The Nikkei's rise and fall seems to indicate that at some point asset purchases
do in fact become destabilizing.

My view is that asset purchases would be most effective if coupled with
fiscal stimulus. Working only through financial markets may be simply too
restrictive to yield broad-based economic improvement. It is almost as if the
Fed is trying to force a fire hose of policy through a garden hose. Keep
turning up the volume, and eventually that hose bursts. And that might be what
we are seeing in Japan.

Bottom Line: Inflation expectations are falling, and that by itself should
complicate the Fed's expectation that they can start scaling back asset
purchases at the end of the summer. But falling inflation expectations may
complicate monetary policy more broadly by revealing the limits to quantitative
easing. And Japan isn't helping.